Money Creation
and Control
CHAPTER
27
CHAPTER CHECKLIST
When you have completed your study of this
chapter, you will be able to
1
Explain how banks create money by making loans.
2
Explain how the Fed controls the quantity of money.
27.1 HOW BANKS CREATE MONEY
Creating a Bank
To see how banks create money, we’ll work through the
process of creating a bank and see how our new banks
creates money.
27.1 HOW BANKS CREATE MONEY
There are eight steps:
• Obtain a license to operate a commercial bank
• Raise some financial capital
• Buy some equipment and computer programs
• Accept deposits
• Establish a reserve account
• Clear checks
• Buy government securities
• Make loans
27.1 HOW BANKS CREATE MONEY
Obtaining a Charter
Apply to the Comptroller of the Currency
Raising Financial Capital
Virtual College Bank creates 2,000 shares, each worth
$100, and sells these shares in your local community.
Balance sheet
A statement that summarizes assets (amounts owned)
and liabilities (amounts owed).
27.1 HOW BANKS CREATE MONEY
Table 27.1 shows Virtual College Bank’s balance sheet #1.
27.1 HOW BANKS CREATE MONEY
Buy some equipment and computer programs
Buy some office equipment, a server, banking database
software, and a high-speed Internet connection.
These items cost you $200,000.
27.1 HOW BANKS CREATE MONEY
Table 27.2 shows Virtual College Bank’s Balance Sheet #2
27.1 HOW BANKS CREATE MONEY
Accepting Deposits
Offer the best terms available and the lowest charges
on checkable deposits.
Deposits begin to roll in.
You have accepted $120,000 of deposits.
27.1 HOW BANKS CREATE MONEY
Table 27.3 shows Virtual College Bank’s Balance Sheet #3
27.1 HOW BANKS CREATE MONEY
Establishing a Reserve Account
Establish a reserve account at local Federal Reserve
Bank.
27.1 HOW BANKS CREATE MONEY
Table 27.4 shows Virtual College Bank’s Balance Sheet #4
27.1 HOW BANKS CREATE MONEY
Reserves: Actual and Required
A bank’s required reserve ratio is the ratio of reserves to
deposits that banks are required, by regulation, to hold.
Suppose that the required reserve ratio is 25 percent of
total deposits.
A bank’s required reserves are equal to its deposits
multiplied by the required reserve ratio.
So for Virtual College Bank,
Required reserves = $120,000 x 25 ÷100 = $30,000.
27.1 HOW BANKS CREATE MONEY
Actual reserves minus required reserves are excess
reserves.
Virtual College Bank’s
Excess reserves = $120,000 - $30,000 = $90,000.
Whenever banks have excess reserves, they can make
loans.
27.1 HOW BANKS CREATE MONEY
Clearing Checks
Virtual College Bank’s depositors want to be able to
make and receive payments by check.
Funds must move from an account at your bank to an
account at another bank.
In the process, one bank loses reserves and the other
bank gains reserves.
Figure 27.1 on the next slide shows how a bank clears
a check.
27.1 HOW BANKS CREATE MONEY
Jay banks at Virtual College.
Jay writes a check for $20,000 on his account at
Virtual College to pay Hal PCs.
Hal PCs banks at First America.
When Hal PCs deposits the check, First American
sends it for collection to the Dallas Fed.
27.1 HOW BANKS CREATE MONEY
The Dallas Fed
increases First
American’s
reserves by
$20,000.
The Dallas Fed
decreases Virtual
College’s reserves
by $20,000.
27.1 HOW BANKS CREATE MONEY
First American
increases Hal’s
PCs’ checkable
deposit by
$20,000.
Virtual College
decreases Jay’s
checkable deposit
by $20,000.
27.1 HOW BANKS CREATE MONEY
First American’s
assets and
liabilities have both
increased by
$20,000.
Virtual College’s
assets and
liabilities have both
decreased
by $20,000.
27.1 HOW BANKS CREATE MONEY
Buying Government Securities
Government securities provide a bank with an income
and a safe asset that is easily converted back into
reserves.
Suppose that Virtual College decides to buy $60,000
worth of government securities.
On the same day, First American decides to sell
$60,000 of government securities.
In reality, a bond broker will match the First American
sale with Virtual College’s purchase.
27.1 HOW BANKS CREATE MONEY
Virtual College buys
$60,000 worth of
government bonds
from First
American.
Virtual College’s
government securities
increase by $60,000
and First American’s
government securities
decrease by that
amount.
27.1 HOW BANKS CREATE MONEY
Virtual College pays
for the bonds by
check.
When the check
clears, the Dallas
Fed increases First
American’s reserves
by $60,000 and
decreases Virtual
College’s reserves
by the same
amount.
27.1 HOW BANKS CREATE MONEY
First American’s assets
are unchanged:
Reserves have
increased by $60,000.
Government securities
have decreased by
$60,000.
27.1 HOW BANKS CREATE MONEY
Virtual College’s assets
are unchanged:
Reserves have
decreased by $60,000.
Government securities
have increased by
$60,000.
27.1 HOW BANKS CREATE MONEY
Table 27.5 shows Virtual College Bank’s Balance Sheet #5
27.1 HOW BANKS CREATE MONEY
Making Loans
With reserves of $40,000 and required reserves of
$25,000, Virtual College has excess reserves of
$15,000.
So the bank decides to make loans of this amount.
27.1 HOW BANKS CREATE MONEY
Table 27.6 shows Virtual College Bank’s Balance Sheet #6
Virtual College has now created $15,000 of new money.
27.1 HOW BANKS CREATE MONEY
Spending a Loan
To spend their loans, the borrowers write checks on
their checkable deposits. Assume they spend the entire
$15,000.
Most likely, the people to whom these checks are paid
do not bank at Virtual College.
The receiving banks send the checks to the Dallas Fed
for collection.
The Fed increases the reserves of the receiving banks
by $15,000 and decreases the reserves of Virtual
College by $15,000.
27.1 HOW BANKS CREATE MONEY
Table 27.7 shows Virtual College Bank’s Balance Sheet #7
The deposits that Virtual College created are now at
some other banks in the system.
27.1 HOW BANKS CREATE MONEY
Limits to Money Creation
When Virtual College creates money and its customers
spend the new money, other banks receive reserves
and have excess reserves.
These banks now create money just like Virtual College
did.
At each stage, the amount of new loans get smaller.
27.1 HOW BANKS CREATE MONEY
When a bank receives deposits, it keeps 25 percent in
reserves and lends 75 percent. The amount loaned
becomes a new deposit at another bank.
The next bank in the sequence keeps 25 percent and
lends 75 percent, and the process continues until the
banking system has created enough deposits to
eliminate its excess reserves.
At the end of the process, an additional $100,000 of
reserves creates an additional $400,000 of deposits.
Figure 27.3 on the next slide shows the multiple
creation of bank deposits.
27.1 HOW BANKS CREATE MONEY
27.1 HOW BANKS CREATE MONEY
Why is the increase in deposits equal to 4 times the
initial increase in reserves?
The answer is because the required reserve ratio is 25
percent (or 0.25).
Once the banking system has excess reserves, banks
keep on lending and creating deposits until all the new
reserves are required.
This outcome occurs when deposits have increased by
1/0.25 (or 4) times the initial increase in reserves.
27.2 INFLUENCING THE QUANTITY OF MONEY
The Fed constantly takes actions that influence the
quantity of money, and open market operations are the
Fed’s major policy tool.
An open market operation is the purchase or sale of
government securities by the Fed in the open market.
27.2 INFLUENCING THE QUANTITY OF MONEY
How An Open Market Operation Works
When the Fed buys securities in an open market
operation, it pays for them with newly created bank
reserves and money.
With more reserves in the banking system, the supply of
interbank loans increases, the demand for interbank
loans decreases, and the federal funds rate falls.
The federal funds rate in the interest rate on loans in the
interbank market.
27.2 INFLUENCING THE QUANTITY OF MONEY
Similarly, when the Fed sells securities in an open
market operation, buyers pay for them with bank
reserves and money.
With fewer reserves in the banking system, the supply
of interbank loans decreases, the demand for interbank
loans increases, and the federal funds rate rises.
The Fed sets a target for the federal funds rate and
conducts open market operations on the scale needed
to hit its target.
27.2 INFLUENCING THE QUANTITY OF MONEY
A change in the federal funds rate is only the first stage
in an adjustment process that follows an open market
operation.
If banks’ reserves increase, they increase their lending,
which increases the quantity of money.
If banks’ reserves decrease, they decrease their
lending, which decreases the quantity of money.
27.2 INFLUENCING THE QUANTITY OF MONEY
The Fed Buys Securities
Suppose the Fed buys $100 million of U.S. government
securities in the open market.
The seller might be
• A commercial bank
• The non-bank public
27.2 INFLUENCING THE QUANTITY OF MONEY
Figure 27.4 shows what happens when the Fed buys
securities from a bank.
27.2 INFLUENCING THE QUANTITY OF MONEY
Figure 27.5 shows what happens when the Fed buys
securities from the public.
27.2 INFLUENCING THE QUANTITY OF MONEY
The Fed Sells Securities
Suppose the Fed sells $100 million of U.S. government
securities in the open market.
The Fed’s assets decrease by $100 million.
The reserves of the banking system decrease by $100
million and banks must borrow in the interbank market
to meet their required reserve ratio.
The change in bank reserves is just the beginning.
A multiplier effect on the quantity of money begins.
27.2 INFLUENCING THE QUANTITY OF MONEY
The Multiplier Effect of an Open Market
Operation
An open market purchase that increases bank reserves
also increases the monetary base.
The increase in the monetary base equals the amount
of the open market purchase, and initially, it equals the
increase in bank reserves.
27.2 INFLUENCING THE QUANTITY OF MONEY
If the Fed buys securities from the banks, the quantity of
deposits (and quantity of money) does not change.
If the Fed buys securities from the public, the quantity of
deposits (and quantity of money) increases by the same
amount as the increase in bank reserves.
Either way, the banks have excess reserves that they
now start to lend.
27.2 INFLUENCING THE QUANTITY OF MONEY
The following sequence of events takes place:
• An open market purchase creates excess reserves.
• Banks lend excess reserves.
• The quantity of money increases.
• New money is used to make payments.
• Some of new money is held as currency—currency
drain.
• Some of the new money remains on deposit in banks.
• Banks’ required reserves increase.
• Excess reserves decrease but remain positive.
27.2 INFLUENCING THE QUANTITY OF MONEY
Figure 27.6
illustrates this
sequence of
events.
The process
repeats until excess
reserves have been
eliminated.
27.2 INFLUENCING THE QUANTITY OF MONEY
Figure 27.7 provides an example of the multiplier effect
of an open market operation with numbers.
• When the Fed provides the banks with $100,000 of
additional reserves in an open market operation,
the banks lend those reserves.
• Of the amount loaned, $33,333 (33.33 percent)
leaves the banks in a currency drain and $66,667
remains on deposit.
• With additional deposits, required reserves
increase by $6,667 (10 percent required reserve
ratio) and the banks lend $60,000.
27.2 INFLUENCING THE QUANTITY OF MONEY
• Of this amount, $20,000 leaves the banks in a
currency drain and $40,000 remains on deposit.
• The process repeats until the banks have created
enough deposits to eliminate their excess
reserves.
• An additional $100,000 of reserves creates
$250,000 of money.
The next slide summarizes this sequence of events.
27.2 INFLUENCING THE QUANTITY OF MONEY
27.2 INFLUENCING THE QUANTITY OF MONEY
The Money Multiplier
The money multiplier is the number by which a
change in the monetary base is multiplied to find the
resulting change in the quantity of money.
Change in
quantity of
money
=
Money
x
multiplier
Change in
monetary
base
27.2 INFLUENCING THE QUANTITY OF MONEY
The larger the currency drain and the larger the required
reserve ratio, the smaller is the money multiplier.
Required reserves = R  Deposits
Currency = C  Deposits
Monetary base, MB, is the sum of required reserves
and currency, so
MB = (R + C)  Deposits
The quantity of money, M, is the sum of deposits and
currency, so
M = Deposits + C  Deposits = (1 + C)  Deposits
27.2 INFLUENCING THE QUANTITY OF MONEY
MB = (R + C)  Deposits
M = (1 + C)  Deposits
So
M
MB
=
M =
(1 + C)
(R + C)
(1 + C)
 MB
(R + C)
Money Creation in YOUR Life
It might surprise you to realize just how big a role you play
in the money creation process.
Every time you charge something to your credit card, you
help the bank that issued your card to create money.
The increase in your outstanding balance is a loan from
the bank to you.
The bank pays the seller right away. So the bank deposit
of the seller and your outstanding balance increase
together. Money has been created.
Cash from the ATM is part of the currency drain.
You and millions of other students play a big role in the
money creation process.